Human capital and the private equity premium

When capital market is imperfect, an entrepreneur has to invest substantial personal funds to start a firm and has to bear large firm-specific risk. Furthermore, if a typical entrepreneur is risk averse, private equity should earn a premium for idiosyncratic risk. In this paper I explore the interaction of human capital with the decision to become an entrepreneur. I calibrate a model of entrepreneurial choice to illustrate a significant attenuating effect of human capital on the premium for firm-specific risk. When an entrepreneur can quit the business and work for hire, the firm-specific risk premium is order of magnitude lower than without this option. While an entrepreneur puts at risk a substantial fraction of financial wealth, she does not commit all human capital to the current business. At stake is only the labor income forgone while managing the firm and the rest of human capital is unaffected by the business risk. Empirical evidence suggests that private equity does not earn any significant premium over publicly traded equity. The model with human capital is consistent with this observation, assuming typical entrepreneur forgoes a small expected return (1.5%) in lieu of intangible benefits of entrepreneurship. (C) 2003 Elsevier Inc. All rights reserved.